Jaimini Bhagwati: Capital markets: What next?

Indian equity markets have a lot of catching up to do with the deeper and more liquid markets.

A number of significant first-generation capital market reforms have been implemented in India.

For instance, spot prices for index (e.g. Sensex) stocks are usually "market"-determined, volumes in derivative markets have grown beyond those in spot markets, and market mechanisms (e.g. the speed of settlement and dematerialisation) are close to international best practices.

Additionally, the NSE and BSE have reached a relatively high degree of sophistication. However, the BSE is not yet corporatised and the NSE could do with more competition.

Capital markets include spot and derivatives securities associated with traded and privately-held equity, debt and exchange rates. Indian debt and currency markets are lagging behind equity markets primarily because their spot prices are less market-determined.

Recent media reports about BPL Communications and Reliance Industries indicate that there are systemic shortcomings in capital market regulation.

In this context, the next set of reforms in the development of capital markets should include coordinated action by the respective regulators as well as the ministry of finance and this topic will be covered in a later article.

The rest of this piece will focus on second-generation reforms to develop our equity markets. The Indian stock market is comparable to developed markets in terms of market capitalisation and trading turnover but is somewhat behind with respect to market depth.

For instance, at the end 2002, the top ten companies accounted for 45 per cent of trading in Brazil, 70 per cent in Mexico, and over 65 per cent in India. The comparable numbers for Japan, the UK, and the US were 25 per cent, 15 per cent, and 15 per cent, respectively.

Currently, about 50 Indian stocks, out of more than the 6,000 listed, make up over 75 per cent of the trading. Further, the proportion of stock available for trading is limited and accordingly, recent FII purchases have raised market valuations sharply.

FII investments in India are small compared to their global portfolios and our markets could be adversely affected by shifting FII preferences based on inter-country risk-return comparisons. Consequently, a concerted effort is needed to widen the base of our equity market.

In the last ten years, significant efforts have been made to improve investor awareness and regulatory oversight.

However, an NCAER"�SEBI "Survey of Indian Investors" of June 2000 reported that only 7.4 per cent of Indian households invested in equity or debenture securities, either directly or through mutual funds.

The comparable number for the UK was 23 per cent, Canada 46 per cent, Germany 18 per cent, France 48 per cent, South Korea 8 per cent, Australia 50 per cent, and the US about 48 per cent.

The survey also revealed that excluding investments perceived as risk-free (e.g. NSC, LIC policies) Indian households rank the following four categories in a descending order of risk preference: (1) bank deposits, (2) gold, (3) UTI and other mutual funds, and (4) stocks, company deposits, debentures, and chit funds.

Indian brokerages, coporates, market analysts and others have been known to use the media to spread misinformation. In most cases, even if wrongdoing is established, it is almost impossible to make good the losses incurred by investors.

As such, given the information asymmetries and recurring episodes of market manipulation, it is understandable that retail investors prefer to invest in public sector debt instruments.

This lack of investor confidence results in significant opportunity costs. For example, stock market investment alternatives can promote savings incentives. In efficient markets, investors are able to readily convert their equity holdings into cash without affecting stock prices.

This ease of exit attracts investors (both domestic and foreign) and enhances capital allocation efficiency (reducing the dependence on pure bank financing) and growth. Further, well-functioning equity markets can lead to a better monitoring of management performance and thereby improve corporate governance.

What else can SEBI do to increase equity market depth and boost investor confidence? In most capital market regulators around the world, including the SEC in the US, more than half the staff is engaged in surveillance and legal functions.

Comparatively, SEBI is inadequately staffed both in the number and strength of its surveillance and legal personnel. To use a military term, SEBI does not have an adequate "teeth to tail" ratio.

The JPC and SEBI reports on stock market, mutual fund and other "scams" of the last ten years clearly indicate the complexity of linkages across brokerages, banks, finance companies, and domestic, overseas corporate bodies.

Consequently, surveillance staff needs to have an adequate "market" background and strong motivation. Further, SEBI's technical capabilities lag those of entities it is meant to regulate, e.g. stock exchanges and brokerages. SEBI also needs to anticipate market anomalies, promote innovation, and relentlessly pursue upgrading technology.

It is difficult for SEBI to attract the talent and doggedness required for its surveillance and market development responsibilities. Today, it is unlikely that graduates from prominent law or business schools would consider starting their careers in SEBI.

However, motivated and talented professionals would join if they sense that they would acquire marketable skills by working in SEBI. Junior positions could be filled through a competitive entrance examination to build a professional cadre much in the same way as the RBI.

By definition, the part-time SEBI board members from the ministry of finance, DCA and RBI cannot attend to SEBI's everyday responsibilities.

It is in recognition of the pressures for SEBI to act in a timely and deterrent manner that the 2002 amendment of the SEBI Act increased the number of full-time board members, the regulator's investigative powers, and the penalties that can be imposed.

SEBI badly needs its complement of three full-time board members who are knowledgeable about capital markets, as prescribed in the amended Act.

It bears mentioning though that even in developed markets only a small fraction of infringements are successfully prosecuted. In out-of-court settlements, fines are usually paid without admission of guilt.

Hence, even with better surveillance and effective legal follow-up it would be unrealistic to expect an immediately higher success rate in the prosecution of comparable infringements in India.

Domestic and international private equity flows in India could be augmented by simplifying exit value calculations. In recent years annual private equity flows have been about 0.6 per cent of GDP for the UK and between 1 and 2 per cent for the US.

If we are able to raise additional private equity capital of about 0.5 per cent of GDP, that would amount to approximately Rs 10,000 crore per annum.

Stock markets are poised to benefit from two factors: (a) a relatively young population; and (b) pension reforms. Most studies indicate that returns on long-term investments in a well-diversified stock portfolio usually exceed those on fixed-income securities.

Therefore, long-term investments in equity should be attractive for the increasing number of young retail investors in middle-income groups. At the end of 2000, about 36 per cent of our population were below 15 and only 4 per cent above 65.

SEBI needs to ensure that the risk-return trade-offs of longer-term equity investments are well understood by younger investors. Similarly, as funded pension schemes become more accessible, this could boost investor interest in equity.

To summarise, Indian equity markets have a considerable amount of catching up to do with the deeper and more liquid markets.

Our efforts need to be focused on: (a) widening the base of the stock market, increasing liquidity and reducing transaction costs for an increasing number of stocks; (b) expanding the universe of traded instruments and upgrading technology; (c) raising retail investor confidence by increasing the effectiveness of surveillance and increasing investor sophistication; and (d) promoting greater self-regulation, transparency, disclosure and competition amongst broker-dealers and stock exchanges.